HAVING traded for years almost oblivious to the notion of risk, China’s bond market, Asia’s biggest outside Japan, has begun exhibiting characteristics of a genuine credit culture, with onshore investors demanding higher premiums for weak borrowers.

    In the past, investors had operated under the belief that the State would always step in to prevent a default.

    But a recent default of a credit product, and growing worries over the proliferation of a shadow banking system extending off balance sheet loans, has made them question old assumptions.

    Hence, lenders have begun differentiating on the basis of industry fundamentals, the degree of State support and balance sheet size, making the credit curves steeper as the gap between the strong and weak names widens.

    “There is no dearth of potential defaulters. But, when there is confidence of a bailout there is no fire sale even in the stressed names, because of confidence that principal will be repaid despite missed coupons,” said Becky Liu, Standard Chartered strategist based in Hong Kong. “The situation is starting to change.”

    In January, AAA-rated Beijing State Owned Asset sold bonds carrying a coupon of 6.48 percent, 242 basis points more than a coupon paid by AA-rated Ningxia Baota Petrochemical.

    Similar bonds sold in December showed a narrower gap between top-tier and second-tier issuers.

    Shaanxi Coal, rated AAA, sold 2018 bonds at a coupon of 6.48 percent, but AA-rated Anhui Foreign Economic Construction had to pay just an extra 132 basis points for its 5-year bonds.

    But while the trends are positive, the situation really is only starting to change, as analysts say most investors still nurture belief that the government will step in rather than allow a default that could drain confidence from the market.

    Unlike in mature markets, where a AA rating is considered strong, investors deem anything below AAA in China to be weak.

    The spread between high and low-risk borrowers has widened to a 21-month high of 105 basis points now, from around 70 basis points in mid-2013, when China’s money markets suffered a short lived liquidity squeeze that sent tremors well beyond its borders.

    Yet, China’s AA-rated bonds currently yield 10-15 percent more than the top-rated borrowers, which is still less than half the spread between top-tier and speculative grade bonds in Western countries.

    Since mid-January, the gap has widened by 20 basis points after Industrial and Commercial Bank of China (ICBC), the world’s largest bank by assets, said it would not finance a repayment to investors in a troubled off-balance-sheet investment product that it helped to market.

    In the end, an unnamed investor stepped in with a bailout, though local media had previously reported that the local government, ICBC and the trust firm would share the costs of a bailout.

    Worries intensified as 3 billion yuan (US$496.20 million) high-yield investment product, backed by a loan to a debt-ridden coal company, failed to repay investors when it matured Jan. 31.

    This month, a high yielding investment product sold via China Construction Bank failed to repay when it matured Feb. 7. Negotiations are ongoing over the return of funds to investors in the product created by Jilin Province Trust Co. and backed by a loan to a coal company, Shanxi Liansheng Energy Co. (SD-Agencies)